'Cautious optimism' for railroad stocks

MEMPHIS, Tenn. (CBS.MW) -- Regional and shortline railroad stocks have been stuck in a rut lately.

"If you look at the right situations, there are some good opportunities for year 2000."

Art Hatfield, Morgan Keegan

But international privatization and a stabilizing interest rate environment could have them chugging along again, says Art Hatfield,transportation analyst at Morgan Keegan. Hatfield told CBS MarketWatch how some companies are competing more aggressively with the trucking industry.

CBS.MW: How's the railroad sector been doing?

Hatfield: It hasn't been doing very well this year. The stocks have been somewhat depressed. They've been kind of down all year. It's not that we've seen them spiral down this year, but they just haven't gone up.

One thing that's impacted things is the increasing interest rate environment. These are generally interest-rate-sensitive stocks. The move by the Federal Reserve to increase interest rates is viewed as a negative because of the indirect relationship between rising interest rates and a slowing economy. Right now things are viewed somewhat cautiously, but with a little bit of optimism underlying that.

I think views right now are that the economy remains strong. I would say for the people I deal with on the regional and shortline side, without a doubt they're saying business is very good here in North America and they're somewhat pleased with the direction things are heading. Keep in mind that over the last several years you've had a lot of these major railroads consolidate. I think we've seen the last of the major consolidations here in the very short term.

When Conrail was broken up between Norfolk SouthernNSC, +0.11%
and CSXCSX, -0.08%
... I would hope for a couple years we probably will not have to deal with anything like that as these railroads integrate and hopefully increase their efficiencies to the point where they're operating very effectively and able to compete aggressively against the trucking companies.

With all that said, I think there's some cautious optimism out there. If you look at the right situations, there are some good opportunities for year 2000.

CBS.MW: Speaking of good opportunities, what are your picks right now?

Hatfield: Right now the only rail name that we're recommending as a "buy" is a company called RailAmericaRAIL, +4.12%
It's a smaller railroad, but they are a holding company of shortline railroads. Shortline railroads are small railroads that connect with the larger railroads and they serve a lot of customers directly and then hand the traffic off to the large railroads to go to destination. They are also a company that's been very aggressive in the international environment.

Internationally, over the last five years we've seen an increasing move by governments around the world to privatize their rail systems. Typically throughout the world railroads were owned by government so they were run as bureaucracies, not run for profit motive. Typically they were filled with political appointees. People who were favorable with the government at the time would get cush jobs in these railroads.

What's happened is that as the world economy has evolved and trade has developed, countries need stronger infrastructures to compete and to grow their economies so governments are turning to privatizing the railroads. It just so happens that the only people in the world who really know how to run a freight railroad are U.S. rail managers. So you've seen a lot of railroads get involved in these privatizations, form investment groups and go down and buy these properties.

RailAmerica, in particular, (is) a 55 percent owner of a rail line in Chile which has been very successful, very profitable. They've been able to turn that around quite nicely. They're also 100 percent owner of the first major rail line to be privatized in Australia. And that has turned around quicker than expected. They've had a good deal of success down there.

One reason we're recommending it now is the valuation. They are in the process of acquiring a company called RailTexrtex
which prior to this merger was actually the largest operator of shortline railroads in the U.S. After this acquisition, based on the current price of RailAmerica, the stock's trading at roughly 1.2 times estimated operating cash flow from the company. So we like the valuation there.

To look longer term, one of the names I like -- and our rating system here is based for 6 months... -- Wisconsin Centralwclx
is a good long term situation. They were the first ones to get involved in international privatization. They own a regional railroad which takes up the state of Wisconsin, goes into Minnesota, up into the upper peninsula of Michigan, actually into Canada and down into Illinois. They started roughly 12 years ago. They've been very successful both domestically and internationally. They were actually the first people to do this by buying the state-owned rail properties in Australia.

More recently though, in 96 and 97, they ended up acquiring virtually all the freight rail operations in the United Kingdom. That situation has had a troubling two, three years. There are a lot of problems there that they haven't been able to fix. In late summer they had a management shake-up at the company.

They're making some changes. I think over the next 12 to 18 months that they can get what they call EWS -- which is the English, Welsh, and Scottish railways -- turned around. That's going to be a very powerful earnings driver for the company, which I think will be a catalyst for the stock over the next 12 months or so.

CBS.MW: What's your opinion of the competition? There's been a great influx of capital out of the TEA 21 bill, the public works bill to rebuild the roads.

Hatfield: Most of that money is going to end up benefiting companies that actually supply to the rail industry, because a lot of that money is going to go to build out transit railroads. The direct benefit to the freight railroads I think from TEA 21 is somewhat minimal. For the commuter rail lines, they're going to benefit by being able to grow, add equipment, add lines, and that's going to benefit the companies who actually do those things, the rail supply companies.... I really don't see a direct benefit to the U.S. freight rail environment.

CBS.MW: What's the outlook for logistics companies with rail? Is it the same as with trucking, that this is the way it's going?

Hatfield: I think everybody needs to offer some sort of logistics options to their customers. I think right now customers look for solutions, not services. Companies need to be able to offer their customers solutions to their logistics needs, and logistics companies can do that.

Sometimes it's not always best to put things on rail trains. Sometimes it's better to put them on trucks, and I think companies need to realize that and they need to offer the best service they can to their clients.

CBS.MW: Who are the clients of the freight trains?

Hatfield: The large shippers. Chemical companies, coal companies, utilities that need to move coals, farmers, all the co-ops around the country that they move grain for.

One of the largest customers to the railroads is UPS
UPS, +0.34%
They put a lot of trucks on trains. That's why they have such good margins, because if you need something to go three days from let's say Chicago to Atlanta and you know you've got the service from the rail lines to do that, you're going to put that in intermodal service because it's much cheaper than having a tractor pull it down there.

When Conrail was first split up, one of the signs that there were significant troubles with the breakup was that UPS pulled all their trucks off the rails. They put them back on the road because the service wasn't there at all.

CBS.MW: What's going to be the catalyst that picks these stocks back up?

Hatfield: I think some confidence from the investment community that the economic outlook is stabilizing. It doesn't necessarily have to pick up pace, but I think concerns that we're going to see some sustained growth in the economy and the threat of inflation and the threat of interest rate hikes kind of goes to the wayside. We may see that some time in the first quarter or as we get out of first quarter and fears of a recession subside, if they do.

There's probably not a lot of downside with a lot of stocks from these levels. So at the first sign of troubling economic times, if these stocks don't head south, it may be a good buying opportunity because they may have shown that they bottomed out.

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